What Qualifies as a Qualified Dividend?

A dividend is a distribution of a company’s earnings to its shareholders. While many dividends are taxed as ordinary income, a specific category known as “qualified dividends” receives more favorable tax treatment. These dividends are taxed at the lower long-term capital gains tax rates, which can result in tax savings. The Internal Revenue Service (IRS) has precise rules for what makes a dividend qualified, involving the stock’s holding period, the type of company paying the dividend, and other conditions.

The Holding Period Requirement

A primary test for a dividend to be considered qualified relates to how long an investor owns the underlying stock. This rule prevents investors from buying a stock just before a dividend is paid and selling it immediately after, solely to capture the dividend at a lower tax rate. The requirement for common stock is that the investor must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

The ex-dividend date is the first day a stock trades without the right to receive the most recently declared dividend. To determine if the holding period is met, an investor must identify this date and then look at the 60 days prior and the 60 days after, creating the 121-day test period. For example, if a stock’s ex-dividend date is June 15th, the 121-day period begins on April 16th and ends on August 14th.

The holding period rules are different for certain types of investments. For preferred stock, the holding period is longer, requiring an investor to have held the stock for more than 90 days during the 181-day period that begins 90 days before the stock’s ex-dividend date. The days the stock is held do not need to be consecutive within the specified period. The IRS also has rules that can pause the holding period clock if the investor uses options or short sales that diminish their risk of loss on the stock.

Source of the Dividend

For a dividend to be qualified, it must originate from a specific type of entity. The most common source is a domestic U.S. corporation. Dividends paid by any corporation formed in the United States will meet this part of the definition, assuming other criteria are satisfied.

Dividends can also be qualified if they are paid by a qualified foreign corporation. A foreign corporation meets this standard if its stock is readily tradable on an established U.S. securities market, such as the New York Stock Exchange or NASDAQ. This includes American Depositary Receipts (ADRs), which represent shares of a foreign company but trade on U.S. exchanges.

Alternatively, a foreign corporation is considered qualified if it is incorporated in a U.S. possession. Another path is if the corporation is eligible for the benefits of a comprehensive income tax treaty with the United States. These treaties contain provisions to prevent double taxation and allow for the exchange of tax information, making their dividends eligible for the lower tax rate.

Payments That Are Not Qualified Dividends

The IRS explicitly excludes certain payments from being treated as qualified dividends, and these distributions are taxed as ordinary income. One example is dividends paid by tax-exempt organizations. Since these entities do not pay corporate income tax, their distributions do not receive preferential tax treatment.

Capital gain distributions from mutual funds and real estate investment trusts (REITs) are also not considered qualified dividends. Similarly, payments from mutual savings banks, cooperative banks, and credit unions that are called “dividends” are actually treated as interest income for tax purposes.

Other specific exclusions apply. Payments received in lieu of a dividend, which can occur when a broker lends an investor’s shares as part of a short sale, are not qualified. Dividends paid on shares held in an Employee Stock Ownership Plan (ESOP) are also not qualified.

Identifying and Reporting Qualified Dividends

For most investors, identifying qualified dividends is guided by the tax forms they receive from their brokerage firm. At the end of the tax year, investors receive a Form 1099-DIV, “Dividends and Distributions,” for each account in which they earned dividend income.

The information for qualified dividends is found in two boxes on Form 1099-DIV. Box 1a reports the total amount of ordinary dividends paid to the investor. Box 1b shows the portion of the amount in Box 1a that may be considered qualified dividends and is eligible for the lower long-term capital gains tax rates.

When preparing their tax return, taxpayers use the figures from Form 1099-DIV to report their dividend income. The total ordinary dividends from Box 1a are reported on Form 1040. To benefit from the lower tax rates, the qualified dividends from Box 1b are used to calculate the tax liability, often by completing the “Qualified Dividends and Capital Gain Tax Worksheet” found in the Form 1040 instructions.